Investor’s perspective: psychology of fundraising

“A compelling narrative fosters an illusion of inevitability.” 
― Daniel Kahneman

Most successful investors in the world have a good understanding of common human (cognitive) biases. Cognitive biases are ‘hard-wired’ in us, and we are all liable to take shortcuts, oversimplify complex decisions and be overconfident in our decision-making process. Thanks to these (intuitive or experience-based) insights, investors have a significantly better understanding of investment opportunities (founding teams and their projects) and are able to systematically use these (behavioural) insights for better decision making, thus improving their investment odds.

There are three aspects for investors to consider in order to select only the best investment opportunities:

  1. Identify and guard against biases in their own (investment-related) decision-making process
  2. Identify biases [paste link to the entrepreneur’s perspective post here] entrepreneurs may use (in their materials/deck/pitching process) to gain a more favourable view of their projects
  3. Identify and assess founders’ biases by observing how/what they pitch

Successful investor puts looks at opportunities via each set of lenses (from above three points) before deciding to invest.

1) Identify and guard against biases in their own decision-making process

  • Confirmation Bias + Loss Aversion. What is it: This is the tendency for people to favor information that confirms their preconceptions regardless of whether that information is true or complete. When layered in with Loss Aversion, it creates a deadly combination. How to defend against it: Because an investor is averse to losses, he is biased against any data that suggests that the initial investment decision was a mistake and will gravitate towards information that supports a follow-on investment. Confirmation-trapped people often seek out others who have made, and are still making, the same mistake.
  • Risk Seeking. What is it: Even if a company is really struggling, the following logic is very appealing: wouldn’t an investor be willing to spend $2M to save the last $8M he has already invested? Because investors usually buy preferred stock, they get paid first and so they only need the company to sell for the value of the preferred stock to get their money back. How to defend against it: As a result, you often see struggling companies raise inside rounds under this logic (often crushing employees’ equity in the process). Basically, investors avoid risk when their portfolios are performing well and could bear more, and they seek risk when their portfolios are floundering and don’t need more exposure to possible losses. This is largely due to the mentality of winning it all back. Investors are willing to raise the stakes to “reclaim” capital, but not to create more capital.

Other impactful biases include:

  • Delayed gratification (pressure to show immediate results)
  • Sunk cost trap (feeling lasting attachment to costs that cannot be recovered)
  • Oversimplification tendency (tendency to stay within your ‘circle of competence’ even when it is clearly counterproductive or destructive)

2) Identify biases founders use to gain more favourable view of their projects

As mentioned in the article, top biases that founders may deliberately use to gain more favourable view of their pitch and project are narrative bias (storytelling in deck and pitching), clustering illusion (that causes investors to observe appealing clusters of information and credentials), confirmation bias (founder shows the ‘right’ structure and contents to investors), pro-innovation bias (investors like to see innovative features and products), halo effect (founders show, via storytelling and credentials, a positive and likeable image or treat of themselves or their product, aiming for investors to think that the overall product and team are as good), zero-risk effect (founders pre-emptively show there are no risks or all potential risks are mitigated) and distinction bias (founders like to deliberately compare their product to one that is much inferior, thus highlighting the benefits).

3) Identify and assess founders’ biases by observing their pitch

  1. Anchoring Trap. What is it: We can be excessively influenced by a starting point or first impression. Psychologists have shown that when people make quantitative estimates, their estimates may be heavily influenced by previous values of the item. For example, it is not an accident that a used-car salesman always starts negotiating with a high price and then works down. The salesman is trying to get the consumer anchored on the high price so that when he offers a lower price, the consumer will estimate that the lower price represents a good value. Anchoring can cause investors to under-react to new information. How to defend against it: In order to avoid this trap, an investor needs to remain flexible in his thinking and open to new sources of information, while understanding the reality that any company can be here today and gone tomorrow.
  2. False Causality Bias. What is it: Many times, we falsely assume when two events occur together that one event must have caused the other. For example, founders are prone to show and quickly get credit for their previous success (exit or company sale). However upon careful analysis of the stated “success” (which a founder assumes to repeat with this new project) may show a confluence of external factors (such as technological development, favourable legislation, government support, etc), good timing and pure luck that were more important in the stated success. PayPal and Amazon are great examples, and founders of both are very careful not to claim full credit, but deliberate on more salient factors that weren’t in their control and how the sum total of their grit, perseverance and external factors helped in their eventual success. How to defend against it: Investors need to hear out founders’ stories but also conduct a thorough analysis of the context in which the previous success of the founder happened. Goal is to distill what really caused the success; was it mostly the hard work, visionary idea and perseverance despite or rather in addition to externalities?
  3. Fundamental Attribution Error. What is it: Whereby we attribute a person’s behaviour to an intrinsic quality of her identity rather than a situation she is in. For example, let’s say you were interviewing a financial advisor. He shows up on time, in a nice suit, and buys lunch. He says all the right words. Will he handle your money correctly? Almost all of us would be led to believe he would, reasoning that his sharp appearance, timeliness, and generosity point towards his “good character”. Dan Ariely’s book about situational dishonesty and cheating illustrates that we may give an appearance that is expected only to behave differently in a similar context. How to defend against it: Before and during the fundraising pitch, we need to dig deeper and put appearances and our expectation in a proper context, aiming to find out whether the founder and his team really have all the necessary attributes (industry knowledge, team skills, leadership, vision for the product) required to give them the best shot at successful growth and scale up of their product.
  4. Survivorship Bias. What is it: Our tendency to focus on successful people, businesses, or strategies and ignoring those that failed.  Because of this, we adopt opinions, structure businesses, and make decisions without examining all the data, which can easily lead to failure. A Google search of “Successful founders who dropped out of college,” will turn up some of the biggest names such as Steve Jobs and Mark Zuckerberg as examples of entrepreneurs who had an idea, took a leap and became successful. But by equating their success to hard work alone, we ignore a very important fact: for every successful college dropout, there are hundreds, if not thousands, who weren’t as lucky.
    The founders we put on pedestals worked hard, but there were also many circumstantial events that paved their way to success. In fact, research shows the majority of the United States’ most successful businesspeople graduated college – 94%, to be exact. How to defend against it: Look out for signs such as “In following legendary footsteps of XXX,” “We have some of the similar pedigree to YYY,” “Our team’s combined experiences in this industry are of ZZZ years”, etc which all have a common denominator of “based on previous success of such and such, we think we have a good chance at similar success.” Again, a more pragmatic assessment of team, product and market related to areas where the founder or his team claims some “heavy” credentials would help understand what the reality is.

In addition to the above, biases investors can look out for in founders include:

  • Information bias
  • Framing cognitive bias
  • Decoy effect
  • Choice supportive bias
  • Empathy gap
  • Illusion of control
  • Overconfidence and overoptimism
  • Scarcity priming

LET'S TALK.

or you may email me at hayk.hakobyan@gmail.com

2019 © Hayk Hakobyan

%d bloggers like this: